Keynesian theory

Basic assumption of model It was the first model to explain why the output fluctuate around its potential output.

There was interdependence between output and spending i.e. spending determines output and output and income determines spending.

Price are constant in the short run Demand is the main component in deciding equilibrium output.

Economy can supply whatever amount of goods are demanded at same price level.

AS curve will be horizontal.

Aggregate demand

It is the sum total of the goods demanded in an economy.

In the Keynesian model, AD= C+ I + G + NX

WHERE C is consumption by household I is investment in machines or capital formation. G is government expenditure NX is net exports i.e. exports - imports

Equilibrium output

It is that level of output at which the aggregate demand is equal to actual output.

AD refers to the planned demand i.e. the amount of output they are planning to demand.

In the figure, AD is plotted and to find the equilibrium we have drawn 45 line . Reason being AD should be equal to Y

Consumption

Consumption function is given by: C= c͞ + cY where C = minimum level of consumption / consumption at zero level of income c = marginal propensity to consume i.e. by how much amount the consumption increase due to increase in the income. numerically it is C / Y if c is 0.9, it indicate that if income rise bi 1$ , then the level of consumption will rise by 90 cents.

Saving function

Income is either consumed or saved.S + C = YS= - C + ( 1-c ) YSaving increases with an increase in income

Investment For convenience investment was assumed to be autonomous

I= I

Aggregate Demand AD= C+ I considering G, NX=0 C = C + c Y I = I AD= C +cY + I = A + c Y

Graphical presentation of aggregate demand

functionAD= A + c YWhere A decide the intercept c decides the slope Higher A , higher Y higher c , higher YE is the equilibrium output.

I

Equilibrium output

AD = YY = A + c YY = 1 A 1 – cAnother method to find the equilibrium is equating saving and investmentReason: AD= C + I Y= C + S for equilibrium AD = Y, implying I = S

multiplier

Multiplier tells the amount by which the equilibrium output will change due to the change in the autonomous aggregate demand.

Suppose in an economy, there is an increase in autonomous aggregate demand by A . Output will increase by this amount. Thus, income also rise by this amount. Spending will increase by c times A. this process will continue so, the change in total output is much more than the initial increase in aggregate demand.

Y= A + c A + c^2 A + ……….

Y= 1 A 1-c

Government sector

There are three components that add to aggregate demand when we include the government sector. These are:1. Government taxes: TA = tY i.e. income tax and t is the tax rate.

2. Government transfers: TR it is the payment that government makes to individuals in form of unemployment benefit, old age benefits etc

3. Government expenditure: G is the expenditure by the government on the goods and services

Aggregate demand in three sector model

AD = C + c( Y+ TR –t Y) + Ῑ + Ḡ = Ᾱ + c( 1-t) YAD will become flatter5And intercept will be higher by the amountḠ + c TR Equilibrium change to E’ and output to Ye’.

aAD’E’

Ye’

Effect on equilibrium output due to change in Ḡ

Effect is same as the change in the autonomous spending.

Multiplier has reduced because the disposable income has reduced. Now, a proportion of income will be given to government as tax Higher the tax , lower

the multiplier. It is just like a

reduction in MPC.

Effect on equilibrium output due to change in tax

rate

Suppose the income tax rate reduced. this will increase the disposable income of the individual by

the amount t Y. Thus the increase in aggregate demand is MPC times change in income. Due to induced spending, income will be generated and aggregate demand will further increase by MPC ( 1-t’) times change in Y. thus total change in equilibrium output is given by :

Effect on equilibrium output due to change in

transfer paymentIt is given by:

Now, the multiplier is less than the government expenditure because the part of the increase of the income is saved. Thus, the effect is less .

Budget surplus

BS = tY -G - TR Where t Y is the tax revenue G is government expenditure TR is transfer payment.

Change in budget surplus due to increase in

government expenditure It has two components:1. the reduction in budget surplus by the amount G

2. Increase in the tax revenue due to the increase in the income. This will increase the surplus by t Y. where

Now, budget surplus = - G+ 1 / t [ 1-c(1-t)] G = - (1-c) (1-t)/ [ 1-c(1-t)]

Change in budget surplus due to increase in tax rate

This will increase the budget surplus by t Y. but this will reduce the disposable income in the economy and thus – t’ Y.

Increase in tax rate will increase the budget surplus , despite the fact that it will reduce the output.

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